What is an Appraisal?
An appraisal is a process leading to an opinion of value. This opinion or estimate is generally arrived at through consideration of three different approaches to value - the Sales Comparison Approach, the Cost Approach, and the Income Approach.
The Sales Comparison Approach is normally the most accurate and best indicator of value for a residential property. Using this method, the appraiser analyzes sales of comparable homes from the subject's market other sales and develops an opinion of the subject properties current market value.
The Cost Approach - which is what it would cost to replace the improvements, less physical deterioration and other factors, plus the land value.
The third approach is the Income Approach, which is most important in appraising income producing properties - it involves estimating what an investor would pay based on the income produced by the property.
The three ways of estimating value in more detail
The cost approach was formerly called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. It is the land value, plus the cost to reconstruct any improvements, less the depreciation on those improvements. The value of the improvements is sometimes abbreviated to RCNLD-reproduction cost new less depreciation, or replacement cost new less deprecation. Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials.
In most instances, when the cost approach is involved, the overall methodology used is a hybrid of the cost and market data approaches. For instance, while the cost to construct a building can be determined by adding the labor and materials costs together, land values and depreciation must be derived from an analysis of the market data. This approach is typically most reliable when used on newer structures, but the method tends to become less reliable as properties grow older.
The underlying premise of the cost approach in appraising market value is that building a substitute property is an alternative to someone who wishes to own such a property. While age is a fairly obvious constraint on that premise, developed urban areas present their own challenges. For instance, if there is little or no vacant land available in a neighborhood, the premise breaks down. Appraising land value is subjective when a scarcity of relevant land sales exists. But also, estimating construction cost is problematic because of an absence of similar construction from which to derive costs. Not only are building codes frequently changing in developed urban areas, but the small number of houses built does not allow the economies of scale available in a new development. The absence of land sales presents more than a data problem for completing the cost approach. The absence of such a market indicates that buyers may not be thinking in terms of building a new home as a substitute for buying an existing home, which tends to expose the unrealistic nature of the underlying premise. Building an individual new home also can be more difficult due to the difficulty in obtaining mortgage financing.
Observe that as the Cost Approach has non-market based components (costs), the approach may not be a good indicator of market value, even when new. This is most noticeable on properties where the market demand is limited. Say for example a military base. The cost to produce the base is not indicative of its market value, even when new. In the US, the government is the only party that would be willing to "buy" this product. This immediate "loss" is a form of obsolescence.
Also observe that this includes "home improvements" that do not recover their costs in the market. A common example in California is the cost of a pool. In most houses, the cost to build a pool is far greater than the increase in market value to the house. This immediate "loss" is again, a form of obsolescence. Accurately determining obsolescence and depreciation (as the property ages) are usually the main problems within the Cost Approach to open market value.
Notwithstanding, the latter challenge must be accepted for insurance purposes. Insurers are interested in insuring structures, not the value of the whole property. After a major disaster, for instance the Oakland Hills Fire of 1991, some perspective is gained on the actual cost of urban construction. The perspective may be through a distorted lens, however. While builders uniformly maintained that costs exceeded those published in cost manuals, the replacement houses, almost as uniformly are larger than those they replaced.
One of the interesting issues in the cost approach is the influence of classical economics. In the example of the swimming pool, above, or many other "home improvements" the relevant question to the homeowner is microeconomic. It is not what the modification in question costs, but rather whether he can modify his existing home more easily and cheaply than buying another house which already has those features. Even in a static market transaction costs related to selling and buying favor home improvements. In an inflationary market, adding the cost of the "improvements" to a decade old cost basis in the property compounds the effect. In a wildly inflationary market it is even dangerous to give up your present home in the hope of replacing it. The price of the replacement home becomes a moving target. This, of course, tends to exacerbate inflation by limiting, at least in the short run, supply.
The sales comparison approach looks at the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject. This approach is generally considered the most reliable, IF good comparable sales exist. In any event, it is the only independent check on the reasonability of an appraisal opinion.
Because this approach applies market derived numeric factors to relate the sold properties to the one being appraised, it is related to Automated Valuation Modeling, below. An interesting perspective on the relationship between relatively subjective human estimation as compared with that obtained by purely mathematic modeling is contained in "Simple Heuristics That Make Us Smart" by Gerd Gigerenzer. Dr. Gigerenzer, a psychologist, asked people to estimate some real world facts based simply on their knowledge, experience and impressions. Common knowledge and some simple rules created models which were close to those produced by multiple regression analysis (MRA) and neural networks. The predictive value of the human models applied to a new sample was a bit better than the mathematical models, suggesting that the mathematical models may have described the data better but missed the predictive relationships. Similarly automated valuation models frequently find building size (square feet or meters) predictive of value, even when that information is not explicitly advertised. This is similar to the example in "The Wisdom of Crowds", Surowiecki, in which the scientist Francis Galton observed a crowd at a fair to, on average, accurately estimate the size of an ox.
The income capitalization approach, often simply called the income approach, is used to value commercial and investment properties. This approach capitalizes an income stream into a present value. This can be done using revenue multipliers or single-year capitalization rates of the net operating income. The Net operating income (NOI) is gross potential income (GPI), less vacancy (= Effective Gross Income) less operating expenses (but excluding debt service or depreciation charges applied by accountants).
Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers.
There are many reasons to get an appraisal
Every year, countless people in the United States buy, sell or refinance real estate. Most of these transactions involve mortgage lenders who require appraisals as verification of the value of the property in question. However, there are many other reasons people order appraisals.
One of the most important issues involved in the buying and selling of a property is developing an opinion of what it's worth so that the seller can set a reasonable and realistic asking price, and the buyer can make an informed offer to purchase. A professional appraisal is the best way for both buyers and sellers to confirm the market value of the property in question. For the relatively small price of this service, both parties can have feel sure that neither one of them is being taken advantage of.
Whether you choose to sell your home on your own or use the assistance of a real estate agent, a professional appraisal can help you make a better educated decision when determining your selling price.
Unlike a real estate agent, an appraiser has no vested interest in what amount the house sells for. It's easy for them to step in and give you the information to help you make your decision. Appraiser fees are based on efforts to complete the report, and not a percentage of the sales price. So seeking a professional appraisal can often help homeowners make the best decisions on investing in their homes and setting a fair sales price.
Before you sell your home, there are several decisions to be made. First and foremost is how much you should try to sell it for. There may be other equally important questions to ask yourself such as "Would it be better to paint the entire house before we sell it?", "Should I put in that third bathroom?", "Should I complete my kitchen remodel?" Many of the improvements made to houses have an effect on their value, but not all improvements have equal effect. For example, a kitchen remodel may improve the appeal of a home, but it may not add enough to the value to justify the expense. On the other hand, a fresh coat of paint may be relatively inexpensive, but may allow for a significantly higher asking price.
If you need to consolidate bills, have a college tuition to pay, or just want to tap into the equity of your home, you'll need a new loan. This usually requires a new appraisal of the property.
Private Mortgage Insurance or PMI is the supplemental insurance that many lenders ask home buyers to purchase when the amount being loaned is more than 80% of the value of the home. Very often, this additional payment is folded into the monthly mortgage payment and is quickly forgotten. This is unfortunate because PMI becomes unnecessary when the remaining balance of the loan - whether through market appreciation or principal pay down - dips below this 80% level. In fact, the United States Congress passed a law in 1998 (the Homeowners Protection Act of 1998) that requires lenders to remove the PMI payments when the loan-to-value ratio conditions have been met.
The costs of the appraisal services required to get a lender to remove PMI payments are usually recovered in just a few months of not paying the PMI.
A divorce can be a particularly traumatic experience for both parties and is often further complicated by the difficult decision of "Who gets the house?" In most divorce cases, the Court won't force the parties involved to "buyout" the other party's interest, but it may order the sale of the home so each party gets an equal share of the equity. It's a good idea to order an appraisal so all parties involved are fully informed as to the true market value of the property in question. If the parties then choose to sell the home, they'll have a better idea of what price to set. If the "buyout" option is chosen, both parties will know they have been fairly compensated.
The settling of an estate from death, or probate, often requires an appraisal to establish Fair Market Value for any real estate involved. The majority of Americans do not have dedicated estate planners or executors to handle these issues. Also, in most cases, a home or other real property makes up a disproportionate share of the total estate value. Typically, the first step in fairly disposing of an estate is to establish its true value. Where real estate is involved, the appraiser can help determine its fair market value, allowing equitable arrangements to be arrived at among the various parties. Everyone walks away knowing they've received a fair deal.
What is the difference between a home inspection and an appraisal?
A home inspector evaluates the physical condition of a building: the structure, construction and mechanical systems, identifies items that should be repaired or replaced, and estimates the remaining useful life of the major systems (such as electrical, plumbing, heating, air conditioning), equipment, structure and finishes. An inspector does not estimate the market value of a home.
An appraisal report is a document that provides an estimate of a property's market value. Lenders require appraisals on properties prior to loan approval to ensure that the mortgage loan amount is not more than the value of the property. In most cases, appraisals done are for lenders the benefit of lenders, and home inspections are for buyers.
Appraiser jargon
Have you heard an appraiser use an unfamiliar term, or found terminology in appraisal report you didn't understand? Appraisers don't intend to speak a foreign language, but every profession has its jargon. Here are some examples of common appraiser jargon and their meanings:
Adjustment: When comparable properties have been identified, the appraiser adjusts the value of the subject property according to differences in living area, acreage, frontage, amenities and the like. This is where the professional expertise of an appraiser is most valuable.
Chattel: Personal property that may be on the subject property but which does not figure into the opinion of value in the appraisal report.
Comparable or "comp": Properties like the subject property nearby which have sold recently, used as a basis to determine the fair market value of the subject property. The Uniform Standards of Professional Appraisal Practice (USPAP) establish clear guidelines for comparable selection.
Drive-by: An appraisal that is limited to examination of comparable sales and a determination that the property is actually there and has no obvious defects or damage visible from the outside. Fannie Mae's form for this type of appraisal is its 2055, so you may hear a drive-by referred to as a "2055."
Fair market value: The appraiser's opinion of value as written in his or her appraisal report should reflect the fair market value of the property -- what a willing seller would pay a willing buyer in an arm's-length transaction.
GLA: "Gross Living Area," the sum of all above grade floor space, including stairways and closet space. GLA is often determined using exterior wall measurements.
Latent defects: A defect on the property that is not readily apparent but which impact the fair market value. Structural damage or termite infestation might be examples.
MLS: A Multiple Listing Service is a proprietary listing of all properties on the market in a given area and their listing prices, as well as a record of all recent closed sales and their sales prices. Created by and used primary by real estate agents, many appraisers pay for access to these databases to aid in comparable selection and adjustment research.
Obsolescence: The value of assets diminishes as their capabilities degrade or more desirable alternatives are developed. Functional obsolescence is the presence or absence of a feature which renders the property undesirable. Obsolescence can also occur because the surrounding area changes, making a feature of the property less desirable.
Subject: Short for the property being appraised -- the "subject property."
Useful life: The time during which a property can provide benefits to its owner.
URAR: Short for Uniform Residential Appraisal Report, Fannie Mae form 1004, it is the form most lenders require if they need a full appraisal (that is, with walk-through inspection).
USPAP: Short for Uniform Standards of Professional Appraisal Practice, USPAP promotes standards and professionalism in appraisal practice, and is often enacted into law in a state. It is promulgated by the Appraisal Foundation, a non-governmental entity chartered by Congress to, among other things, maintain appraisal standards.
Walk-through: An inspection that includes a visit to each part of the interior of the house used in estimating value.
Rent schedule: A statement of proposed rental rates, determined by the owner or the property manager or both, based on a building's estimated expenses, market supply and demand and the owner's long-range goals for the property.
Operating Income Statement: The lender should use this form to determine the amount of operating income that can be used in evaluating the applicant's credit on applications for conventional mortgages that are secured by one-family investment properties and all two- to four-family properties (including those in which the applicant occupies one of the units as a principal residence).
The three types of obsolescence
There are three types of obsolescence or flaws that cause properties to lose value:
Functional Obsolescence: Functional obsolescence occurs when a property loses value due to its architectural design, building style, size, outdated amenities, local economic conditions and changing technology.
Economic Obsolescence: Economic obsolescence occurs when a property loses value because of external factors such as local traffic pattern changes or the construction of public nuisance type properties and utilities such as county jails and sewer treatment plants on adjoining property.
Physical obsolescence: Physical obsolescence occurs when a property loses value due to gross mismanagement and physical neglect resulting in deferred maintenance that's usually too costly to repair.
A typical older home may suffer from the following examples of obsolescence:
- rooms of improper size
- features no longer useful, such as a coal chute with a gas-fired furnace
- out-of-date plumbing, heating, and electrical fixtures and systems -
- inadequate insulation
- unsuitable architectural style
- construction materials that require excessive Maintenance
- undesirable location
How does an appraiser measure the living area of a house?
The following is a description of the generally accepted method of measuring a house. While this is the generally accepted "best practice", there may be significant local market variations.
The ANSI Standard for Measuring Houses
In April, 1996 the American National Standards Institute (ANSI) adopted a standard for measuring single-family residential buildings. American National Standard Z765-1996 was developed through a process of consensus among a wide variety of participants. These included the American Institute of Architects, the Appraisal Foundation, the Building Owners and Managers Association, the Manufactured Housing Institute, the National Association of Realtors, Fannie Mae, Freddie Mac, HUD and others.
The ANSI standards are not law, only a voluntary guide, and are subject to periodic review and revision. But anyone using these standards must apply them as a whole, and not just pick out the parts they like or agree with. The standards are intended for both attached and detached single family residences, but not for apartments or multi-family residences.
The ANSI standards base floor area calculations on the exterior dimensions of the building at each floor level, and include all interior walls and voids. For attached units, the outside dimension is the center line of the common walls. Internal room dimensions aren't used in this system of measuring.
The ANSI standards define "finished area" as "an enclosed area in a house suitable for year-round use, embodying walls, floors, and ceilings that are similar to the rest of the house." Measurements must be taken to the nearest inch or tenth of a foot, and floor area must be reported to the nearest square foot. Garages are specifically excluded.
Basements and Below-Grade Floor Areas
The ANSI standards make a strong distinction between above-grade and below-grade floor area. The above-grade floor area is the sum of all finished square footage which is entirely above ground level. The below-grade floor area includes spaces which are wholly or partly below ground level.
Disregard the old rules of thumb that allow you to include below-grade areas if they are less than five feet below grade, or if less than half the area is below grade. If the house has any areas below the natural grade, measure that whole level separately. Even if the below-grade areas are fully finished, they are not part of the finished floor area according to ANSI standards.
Attics, Lofts and Low Ceilings
Level ceilings must be at least 7 feet high, and at least 6 feet 4 inches under beams, ducts and other obstructions. There is no height restriction under stairs. If a room has a sloped ceiling, at least one-half of the finished floor area must have a ceiling height of at least 7 feet. Otherwise, omit the entire room from the floor area calculations. If a room with a sloped ceiling meets the one-half-of-floor-area-over-7-feet requirement, then include all the floor space with a ceiling height over 5 feet.
Lofts and finished attics must be accessible by a conventional stairway or other access to be counted. If you can only reach the loft by climbing a ladder, it's not part of the finished floor area regardless of the ceiling height.
Detached Rooms, Guest Cottages, Granny Units and Dwelling Units
According to the ANSI standards, finished areas which are not connected to the main residence by a finished hall or stairway must be listed separately. If you have to leave the house to get to the room, it's not part of the finished floor area.
The Mendocino County Zoning Ordinance defines several types of detached living areas. The County calls these "detached bedrooms," "guest cottages," "family care units (granny units)" and "dwelling units."
A detached bedroom is a separate structure containing one room only without a kitchen or bathroom. It must be designed for and intended to be used as a sleeping or living facility for family members. It must be used in conjunction with the main house which includes a kitchen and a bathroom. Detached bedrooms can't be located farther than 150 feet from the main house and can't exceed 500 square feet in floor area.
A guest cottage is like a detached bedroom with a bathroom, but no kitchen. It can't exceed 640 square feet in floor area and must be a permanent structure, not a trailer or mobile home. It can't have a kitchen, wet bar or any provision for appliances for the storage or preparation of food. It must be clearly subordinate and incidental to the main house. Guest cottages can't be rental units. They must be used without compensation by guests of the occupants of the main house.
A family care unit (sometimes called a granny unit) is determined more by use than design. It is the temporary use of a building, structure or trailer to provide housing for the following.
- not more than two adults who are 60 years of age or older; or
- immediate family members who require daily supervision and care; or
- people who provide daily supervision and care for the people who reside in the main residence
A full dwelling unit is a single unit providing complete, independent living facilities for one or more people, including permanent provisions for living, sleeping, eating, cooking and sanitation. A dwelling unit can have only one kitchen.
Room Counts, Bedrooms and Bathrooms
The real estate profession often describes houses by their total room count, the number of bedrooms and the number of bathrooms they contain. For example, the shorthand convention "5/2/1.5" describes a house with 5 rooms, 2 bedrooms and 1.5 bathrooms.
Local custom determines the definition of a "room." In general, a room is a kitchen, a bedroom, a living room, a dining room, a family room, an office or a den. Bathrooms, laundry rooms, sun rooms, lofts, closets, storage rooms and entries are not usually considered to be rooms.
What is the difference between a den and a bedroom? If the den can function as a bedroom, there may be no difference at all. What is the difference between a dining area and a dining room? If you could add walls and it would remain functionally the same, a dining area can be called a dining room.
A bedroom is any room that you can fit a conventional bed into. Usually the local zoning, building or health codes establish minimum requirements for bedrooms. In general, bedrooms should be at least 90 square feet in size, with at least one bedroom in the house 120 square feet in size. Bedrooms should have a window which provides an emergency exit, natural light and ventilation.
Bedrooms should have direct access to a hallway, living room or other common area. You should not have to walk through one bedroom to get to another. A bedroom should have a closet, but this is optional. Before closets, people stored their clothes in armoires and dressers.
Local custom also defines the bathroom. In most parts of the country, a full bathroom includes a toilet, a sink, a bathtub and a shower. A combination bath and shower counts as two fixtures. If the bathroom has only three fixtures it is a 3/4 bath. If it has only two fixtures it is a 1/2 bath, and if it has only one it is a 1/4 bath.
Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
Uniform Standards of Professional Appraisal Practice or USPAP and the Appraisal Standards Board
The Uniform Standards of Professional Appraisal Practice (USPAP) are the generally accepted standards for professional appraisal practice in North America. USPAP contains standards for all types of appraisal services. Standards are included for real estate, personal property, business and mass appraisal. The purpose of USPAP is to promote and maintain a high level of public trust in appraisal practice by establishing requirements for appraisers. The Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989 cites USPAP as the standard to be enforced by state real estate appraiser licensing and certification boards. USPAP compliance is also required by professional appraisal associations, client groups and by dozens of federal, state and local agencies.
Any state certified professional real estate appraiser who is appraising a property has agreed to operate according to these standards. Through FIRREA, the Federal government has mandated that the states enforce real property appraiser's compliance to USPAP. Professional appraisal associations also have the authority to enforce USPAP compliance by their members.
The Appraisal Standards Board (ASB) is an independent Board of The Appraisal Foundation. The ASB is responsible for writing, amending and interpreting the Uniform Standards of Professional Appraisal Practice.
Automated valuation models (AVMs).
Automated valuation models are computer programs for estimating the value of real estate that rely on statistical models such as multiple regression analysis and geographic information systems (GIS). While AVMs can be quite accurate, particularly when used in a very homogeneous area, there is also evidence that AVMs are not accurate in other instances such as when they are used in rural areas, or when the appraised property does not conform well to the neighborhood. This is most evident where there is a "revitalization" of a particular area or neighborhood.
There can exist within a single city block homes that are in poor condition to homes that have been completely rehabilitated and are in good to excellent condition. The differential of sales prices can be demonstrated to be from 50% to 125%. This can lead to an inaccurate model. In San Francisco, California, something like half of price can be predicted using readily quantified measures and a multiple regression (MRA) AVM. In suburban Redwood City, California, by contrast, over 90% of price can normally be captured.
Extreme caution should be exercised when relying on AVMs, especially if the user is unfamiliar with modeling and the math. Because of the limitations, AVMs have begun to fall out of favor with many lenders but are widely used in other appraisal problems such as mass appraisals for ad valorem real estate tax purposes. One of the problems of using AVMs for lending purposes is control of inputs and results. Everyone in the loan origination process is interested in some way in making the loan. Modifying the inputs (boundary of comparable search, even size of building) to create a favorable answer is a mighty temptation. Even foreclosure is unlikely to result in regret if the mortgage has been securitized and the originator gets paid to service the loans in the package.
In property tax assessment, by contrast, there are contesting interests and a quasi-legal dispute resolution process. The assessor, arguably, wants assessments as high as defensibly possible. The taxpayers, clearly, want their assessments low. Disputes are normally adjudicated in assessment appeal. The county assessor is frequently an elected office. The contest of interests tends to refine the accuracy of the valuation results.
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